Conduit rules under section 7701(l) of the Internal Revenue Code.

On June 17, 1994, Tax Executives Institute submitted the following comments to the Internal Revenu regulations under section 7701(l) of the Internal Revenue Code. The Institute's comments on the so-c was prepared under the aegis of TEI's International Tax Committee, whose chair is Lisa Norton of Ing The following members of the Institute also contributed materially to the preparation of the Institu Bergquist, Apple Computer Co.; Joseph E. Bernot, AT&T Global Information Solutions Co.; Lester D. Ez Co.; Stephen H. Finnegan, McDonald's Corporation; Matthew H. Paull, McDonald's Corporation; and Raym Rossi, Intel Corporation.

The Omnibus Budget Reconciliation Act of 1993 added section 7701(l) to the Internal Revenue Code which authorizes the Secretary of the Treasury to issue regulations recharacterizing certain "multiple-party financing transaction[s]." In response to the government's request for taxpayer guidance before the regulations are issued, Tax Executives Institute submits the following comments on the scope of the impending regulations under section 7701(l).

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our approximately 5,000 members represent 3,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works ae one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the anti-conduit regulations contemplated by section 7701(l) of the Code.

Overview

Section 7701(l) provides that --

The Secretary may prescribe 

regulations recharacterizing

any multiple-party financing

transaction as a transaction

directly among any two or

more of such parties where

the Secretary determines

that such recharacterization

is appropriate to prevent

avoidance of any tax imposed

by this title. Although [section 7701(l)'s] grant of rulemaking power is broad, it is not without limit. The statute circumscribes the grant of regulatory authority in two ways: (i) the rules under section 7701(l) must address themselves to a multiple-party financing arrangement, and (ii) the exercise of the IRS's authority under the statute must be premised on a determination that the particular arrangement must be recharacterized to prevent tax avoidance. If these conditions are met, the IRS may recharacterize the transaction as a transaction between two or more entities, in order to reverse the unwarranted tax benefits.

Section 7701(l) was enacted in 1993 to address Congress's concern that taxpayers may be avoiding U.S. tax by intricately structuring financial transactions that utilize multiple entities, where the use of one or more of those entities serve no commercial purpose. See H.R. Rep. No. 103-213, 103d Cong., 1st Sess. 185 (1993) (Conference Report); H.R. No. 103-11, 103d Cong., 1st Sess. 729 (1993) (House Report). The legislative history cites several cases and rulings as examples of three-party arrangements that were to fall within the ambit of the provision, including Aiken Industries v. Commissioner, 56 T.C. 925 (1971), acq. on another issue, 1972-2 C.B. 383(1)(*); Rev. Rul. 87-89, 1987-2 C.B. 195(2); and Technical Advice Memorandum 9133004 (May 3, 1991)(3). Congress intended the provision to apply not only to back-to-back loan transactions, but also to multiple-party transactions involving debt guarantees or equity investments. Conference Report at 186. Section 7701(l) is thus a statutory arrow in the government's quiver to attack financing arrangements that exalt form over substance. See, e.g., Commissioner v. Court Holding Co., 324 U.S. 331 (1945).

TEI recognizes the government's need to address, somehow, abusive efforts by taxpayers to exalt form over substance by structuring financing arrangements. Such arrangements may involve only related parties, or they may involve an unrelated party acting in concert with the taxpayer. Section 7701(l), however, does not add to the authority already vested in the Treasury and IRS to attack sham arrangements. Rather, the provision is intended to facilitate the government's enforcement efforts by undergirding administrative guidance on the kinds of arrangements that will be disregarded for U.S. tax purposes. The grant of authority is so vague--and therefore potentially broad--however, that taxpayers understandably view the new statute with concern. Absent reasonable guidance, section 7701(l) will hang over taxpayers like a sword of Damocles, threatening to crash down on sound, as well as abusive, arrangements. In other words, we are concerned that examining agents may, without guidance, equate legitimate "tax planning" with impermissible "tax avoidance." See, e.g., Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (Hand, J. ("A transaction, otherwise within an exception of the tax law, does not lose its immunity, because it is actuated by a desire to avoid, or, if one chooses, to evade taxation."), aff'd 293 U.S. 465, 469 (1935) ("The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, cannot be doubted.").

We commend the IRS and Treasury for emphasizing the need for immediate guidance for taxpayers structuring highly complex financial transactions. Section 7701(l) will be workable and administrable, however, only if the regulations provide certainty concerning (i) when a financing transaction will be recharacterized and (ii) what the consequences of that recharacterization will be. Our members are concerned that transactions having a legitimate business purpose (and therefore real economic substance) not be swept within the reach of this provision. We are particularly concerned about the effect of the rules on transactions such as guarantees or other credit enhancements given in the ordinary course of business and permanently committed equity capital--which we do not believe constitute the type of "financial engineering" the provision was intended to cover.

Limitation to Specific Code Provisions

TEI strongly recommends that the regulations be limited in scope to specific sections of the Code. As the legislative history of section 7701(l) demonstrates, the application of conduit principles to financing arrangements has been with respect to investments in U.S. property under section 956 and the 30-percent withholding tax under sections 1441 and 1442. Another provision that may properly be addressed under the conduit rules is section 1630) (relating to earnings stripping).

TEI does not believe that the arrangements targeted by the statute can be adequately addressed under a broad, general rule. Each of the listed Code provisions has its own set of standards and attribution rules that must be addressed separately. For example, for purposes of section 956, an investment in U.S. property includes stock of a domestic corporation only if that corporation is at least 25 percent owned by the controlled foreign corporation or its U.S. shareholder. In contrast, under sections 1441 and 1442, differences in tax consequences attributable to the parties' relationships are generally determined under applicable treaty provisions. Exceptions to withholding may also be provided in the Code itself, for example, as in section 871(h) for portfolio interest that is paid to a 10-percent shareholder. These statutory distinctions do not lend themselves to one general, overarching rule.

Moreover, there may also be entity distinctions that need to be addressed in the regulations. For example, an entity's status as a partnership for U.S. tax purposes may not be relevant for withholding tax purposes, but is for purposes of section 956. Perhaps more important, specificity is needed to permit taxpayers to predict the tax consequences of complex financing transactions and to ensure that the pricing of a transaction is sound. Taxpayers need certainty in their financing arrangements, particularly where a transaction involves an unrelated party that may otherwise be reluctant to enter into a transaction. We seriously doubt whether a clear standard could be designed to determine when a transaction will be recharacterized without tailoring the rules to the requirements of specific statutory provisions. Limiting the section 7701(l) rules to specific Code sections will foster the goal of certainty and reduce audit disputes. What's more, no harm can flow to tax policy or the fisc with this approach since transactions not specifically addressed in the regulations may nevertheless be challenged under general substance-over-form principles.(4)

Even if the Institute's recommendation to apply section 7701(l) to specific Code provisions is rejected, the regulations should have no application, at least initially, outside the international area. The provision should not be expanded to the domestic area until clear rules have been issued in the international area, and taxpayers (as well as the government) have had an opportunity to assess how those rules operate in practice. Again, a cautious approach to extending the rules to the domestic arena would not affect the IRS's ability to challenge financing arrangements under existing authorities and case-law principles.

What Constitutes a "Multiple-Party Financing Transaction"

The new statute has generated considerable uncertainty concerning what constitutes a "multiple-party financing transaction." The legislative history of the provision contemplates two or more parties, at least two of which must be related or acting in concert, involved in a transaction that generates interest income. The Conference Report discusses only two such financing arrangements: (i) loans by a controlled foreign corporation to a related U.S. borrower that are treated as an investment in U.S. property under section 956; and (ii) payments of interest by U.S. persons to related foreign persons that may be subject to the 30-percent withholding tax, exempt as portfolio interest, or subject to treaty relief Conference Report at 185-86. In light of the potentially broad scope of the term "financing transaction," we recommend that the regulations be limited to those transactions cited in the legislative history.

Determining When an Inappropriate "Avoidance of Tax" Exists

Section 7701(l) provides that a transaction will be recharacterized only "when appropriate to prevent the avoidance of any tax" imposed under the Internal Revenue Code. The use of the word "appropriate" to describe the circumstances under which the IRS may disturb taxpayers' contractual relationships presents an unmistakable requirement of administrative reasonableness. This limitation is underscored by the legislative history of the provision:

By granting regulatory authority

to provide detailed

rules in this complicated

area, the [House Ways and

Means] committee seeks to

bolster the Treasury's ability

to prevent unwarranted

avoidance of tax through

multiple-party financial engineering,

as well as to provide

a mechanism for issuing

additional guidance to taxpayers

entering into financial

transactions. House Report at 729 (emphasis added). Thus, not all transactions that result in a tax savings to the taxpayer are to be recharacterized; the recharacterization must be "appropriate" and the tax savings must be "unwarranted."

The term "avoidance of any tax" is undefined in the statute or the legislative history. Cases and rulings cited in the legislative history look to two tests to determine whether a tax-motivated, multi-party transaction should be recharacterized: (i) whether the intermediary has complete dominion and control over the funds; and (ii) whether the transaction would have been entered into by unrelated parties (sometimes referred to as the "independent transaction test"). While we recognize that there are drawbacks to using one or both tests, we believe the standards which have been explicated in judicial decisions and rulings can helpfully be adapted in this context.

A. Complete-Dominion-and-Control Test. The case most often cited as authority for applying the complete-dominion-and-control test in the context of a multi-party financial transaction is Aiken Industries. There, the Tax Court found that the multiple-party transaction--i.e., a loan to a U.S. subsidiary from its Bahamian parent that was assigned to a related Honduran corporation for collection-lacked any "valid economic or business purpose." The court viewed the transaction, as follows:

Industrias [the intermediary],

while a valid Honduran corporation,

was a collection

agent with respect to the interest

it received from MPI 

[the U.S. borrower]. Industrias

was merely a conduit for

the passage of interest payments

from MPI to ECL [the

Bahamian lender], and it cannot

be said to have received

the interest on its own. Industrias

had no actual beneficial

interest in the interest

payments it received, and in

substance, MPI was paying

the interest to ECL which "received"

the interest within the

meaning of article IX [of the

U.S.-Honduran treaty which

exempted the payments from

U.S. withholding tax]. 56 T.C. at 934. TEI suggests that the "complete-dominion-and-control" test set forth in Aiken Industries is a proper standard for determining whether a conduit exists for purposes of avoiding the withholding tax.(5)

B. The Independent Transaction Test. The independent transaction (or "would-not-have-been-made") standard may be more appropriate for purposes of section 956. In Rev. Rul. 87-89, the IRS ruled that if the loan were an independent transaction that would have been made on the same terms without the corresponding deposit, then the form of the transaction would be respected for U.S. tax purposes. Whether the loan would have been made under such circumstances is to be determined under a facts-and-circumstances test. While a subjective would-not-have-been-made standard may be difficult to apply, we regret that the development and application of more objective criteria may not be feasible.(6)

To alleviate some of the uncertainty surrounding the use of a subjective test, the regulations should identify as many objective factors as possible. We recommend that these factors create a presumption of nontax avoidance motive in appropriate cases. At a minimum, the following factors should be taken into account in determining whether the transaction would otherwise have been entered into:

* Whether the parties are related and, if not related, whether the intermediary had actual knowledge of the second transaction;

* Whether the financial intermediary (whether or not related) engages in similar business activity with unrelated parties on similar terms and conditions;

* Whether a statutory or contractual right of offset exists;

* Whether a legitimate business purpose (including the reduction of foreign taxes(7)) exists for the transaction;

* Whether the transaction satisfies the section 482 requirements; and

* Whether the financial intermediary satisfies a treaty limitation-on-benefits provision.

In addition, we recommend that--before a recharacterization is effected--evidence must be adduced showing the transaction to constitute an abuse of existing tax policy. The mere existence of an intermediary should not, by itself, result in a recharacterization of the transaction. There are many legitimate uses of financing intermediaries, including ensuring compliance with foreign laws. In other words, although the presence of an intermediary may justify an inquiry into the nature of the transaction, it should not, without more, serve as the basis to disregard the form of the transaction.(8)

What Does it Mean To Recharacterize a Transaction?

The statute provides that if an avoidance of tax exists, the transaction may be "recharacterized." There is no guidance in the legislative history on what the consequences of recharacterization are. Is the recharacterization always adverse to the taxpayer? If one leg of the transaction generates interest income and the other generates dividend payments, which character controls?

The term "recharacterize" apparently contemplates recasting the covered transaction in accordance with its economic substance, as well as rearranging the transaction to vitiate its unwarranted tax benefits. Complex, structured financial transactions are the product of many difficult compromises that result from sometimes discordant legal, regulatory, and commercial constraints, as well as tax considerations. The resolution of these competing concerns will invariably affect the transaction's pricing. Flexibility, especially in the context of arm's-length dealing, is vitally important to preserve the ability of U.S. corporations to compete in the global marketplace. Thus, TEI believes that not every transaction that results in a decrease in taxes should be recharacterized. Where there is no other substantial economic benefit, recharacterization may be appropriate. In contrast, if the transaction has a legitimate business purpose or a substantial economic effect, it should be recognized for tax purposes.

Limitation-On-Benefits Provisions under Existing Treaties

Structures that qualify under limitation-on-benefits (LOB) treaty provisions should explicitly be afforded a presumption of non-tax avoidance purpose under section 7701(l). Absent such a presumption, it will be difficult for taxpayers to arrange financing transactions with any reasonable degree of certainty. In addition, the failure to recognize transactions satisfying such provisions could lead treaty partners to view the regulations as a de facto override of existing treaty obligations.(9)

Treatment of Pledges and Guarantees

The legislative history of section 7701(l) provides that the provision may apply to other financing arrangements, including debt guarantees.(10) Conference Report at 186. Subjecting all financing transactions using a pledge or guarantee to recharacterization would be unreasonable and could disrupt legitimate financial arrangements. A mere guarantee or pledge, for example, should generally not be viewed as equivalent to a borrowing by the guarantor. We suggest that the IRS consider an approach similar to the section 956 rules for treatment of conduit financing arrangements. Under Treas. Reg. [section] 1.956-2(c)(4), a U.S. person will be considered a mere conduit in a financing arrangement if a controlled foreign corporation pledges stock of its subsidiary (also a CFC) to secure the obligation of the U.S. person, where the following conditions are met:

* The U.S. person is a domestic corporation that is not engaged in the active conduct of a trade or business and has no substantial assets other than those arising out of its relending of the funds borrowed by it on such obligation to the CFC whose stock is pledged; and

* The assets of the U.S. person are at all times substantially offset by its obligation to the lender.

Effective Date

Given the potential scope of section 7701(l), TEI strongly recommends that the regulations be issued on a prospective-only basis. Moreover, the regulations should apply only to multiple-party financing transactions entered into on or after the date on which final regulations are issued. See, e.g., Temp. Reg. [section] 1.304-4T (conduit financing principles applied to "acquisitions of stock occurring on or after June 14, 1988"); Temp. Reg. [subsection] 1.956-1T(b)(4)(ii) & (e)(5)(ii) (regulation is effective June 14, 1988 with respect to investments made on or after June 14, 1988); Treas. Reg. [section] 1.956-2(c)(2) (paragraph applies only to pledges and guarantees made after September 8, 1980). The treatment of prior arrangements should be determined under existing law.

Conclusion

TEI is pleased to have this opportunity to set forth its views on the implementation of the conduit rules under section 7701(l). The Institute will submit additional comments when the proposed regulations are issued. In the interim, should you wish to discuss the issues addressed above, please do not hesitate to contact Lisa Norton, chair of TEI's International Tax Committee, at [phone], or Mary L. Fahey, of the Institute's professional staff, at [phone]. (*) Footnotes printed on page 308.

--Notes--

(1) In Aiken Industries, the Tax Court recharacterized a back-to-back loan arrangement where the first part of the transaction was afforded treaty protection and the second part was not. Specifically, the parent company in a non-treaty country lent money to a U.S. subsidiary and assigned the note to another subsidiary in a country with a favorable treaty with the United States. The recharacterization of the arrangement caused the interest payment from the U.S. borrower to the parent (through the subsidiary in the treaty country) to be subject to the 30-percent withholding tax. Characterizing the intermediary corporation as a mere "conduit," the Tax Court noted that the transaction had no economic or business purpose but existed only to avoid U.S. taxation through the use of treaty benefits. 56 T.C. at 934. (2) Rev. Rul. 87-89 involved three financing arrangements where an unrelated financial institution was interposed between the two related parties, one of which borrowed money from a bank in which the other had made a deposit. The ruling finds that unrelated parties would not have made the loan without the corresponding deposit; the loan was treated as a direct loan from the foreign subsidiary to the U.S. parent, subject to section 956. (3) TAM 9133004 involved the recharacterization of a financing arrangement between three related parties where the matching payments from the intermediary to the parent represented dividends, not interest. (4) There are four judicially created doctrines that have been employed to disregard formal contractual relationships in order to reflect economic reality: the sham-transaction, business-purpose, step-transaction (often used in conjunction with a business-purpose test), and assignment-of-income doctrines. The conduit analysis that is the focus of section 7701(l) is, in effect, a fact-specific formulation of the business-purpose doctrine that in other contexts (primarily corporate reorganizations) has been expressed as a "transitory disregard" or "transitory ownership" concept. See, e.g., Rev. Rul. 87-66, 1987-2 C.B. 168; Rev. Rul. 67-274,1967-2 C.B. 141; and General Counsel Memorandum 35267 (March 14, 1973). But see United States v. Cumberland Public Service Co., 338 U.S. 451 (1950); Esmark, Inc. v. Commissioner, 90 T.C. 171 (1988); and Rev. Rul. 84-111, 1984-2 C.B. 88, revoking and superseding Rev. Rul. 70-239, 1970-1 C.B. 74. (5) See also Rev. Rul. 84-152, 1984-2 C.B. 381 (Antilles subsidiary lacked complete dominion and control over U.S. subsidiary's interest payments; interest payments therefore considered derived by foreign parent); Rev. Rul. 84-153, 1984-2 C.B. 383 (interest payments made by U.S. subsidiary to U.S. parent's Antilles subsidiary not exempt under U.S-Netherlands treaty because Antilles subsidiary lacked dominion and control over funds). (6) The independent transaction standard has been applied in other areas. See, e.g., Temp. Reg. [section] 1.861-11T(e)(3) (if a member of an affiliated group makes a loan to a nonmember that on-lends to a member borrower, transaction may be treated as if the member lender made the loan directly to the member borrower, so long as the loan by the nonmember "would not have been made or maintained on substantially the same terms irrespective of the loan of funds by the lending member to the nonmember or other intermediary party"). (7) See Rev. Rul. 89-101, 1989-2 C.B. 67 (business purpose requirement under section 355 is satisfied where first-tier foreign subsidiary distributes second-tier foreign subsidiary stock to U.S. parent in order to reduce amount of foreign withholding tax). (8) See United States v. Cumberland Public Service, 338 U.S. 451 (1950), distinguishing the Court Holding Co. case and declining to disregard a shareholder's ownership of certain assets under a transitory analysis in spite of a pre-existing obligation because the asset acquisition was not the sine qua non of the distribution. (9) The failure to satisfy an LOB article may actually have worse results than running afoul of the conduit rules because it results in a complete denial of treaty benefits. In contrast, under the conduit rules, the transaction would at least be governed by the treaty between the United States and a third country. (10) The treatment of loan guarantees is an area where taxpayers have received very little guidance. See Rev. Proc. 94-7, 1994-1 I.R.B. 174, 175 (IRS will not issue rulings on whether a pledge of stock of a controlled foreign corporation is an indirect pledge of the assets of that corporation under Treas. Reg. [section] 1.956-2(c)(2)).